Operational Alpha: An asset class in its own right

Thu, 17/07/2014 - 07:56

The hedge fund industry is a fast paced dynamic industry, with recent changes in investor demands and regulatory oversight forcing expenses up and fees down. As a result, the industry is undergoing a paradigm shift - driven in large part by technology innovation - to meet these changing operational requirements.

Within the need to meet these changes a new model is emerging; one that enables hedge funds to generate ‘operational alpha’. This is a concept that is becoming equally as important to fund managers as generating performance alpha and is based on the premise that an integrated front-to-back-end infrastructure hosted on a cloud platform delivers greater cost efficiency and controls.

“Operational alpha is about hedge funds reallocating capital, once reserved for unduly expensive operations, back to the front-office,” says Robert O’Boyle, Executive Vice President and Director of Sales & Marketing at New York-based Liquid Holdings. The firm provides a cloud-based, end-to-end platform for hedge funds that want a future-proof, legacy-free operational set-up.

There is no denying that operational alpha is real. It’s about enabling hedge funds to right-size their operational expenditures to be free to invest more capital into alpha generating research, analytics, personnel, and core fund marketing activities over time. The solutions now exist and are more readily available than ever before.
Cost savings and enhanced performance go hand in hand. Simply put, if the manager can leverage a leaner, meaner systematic infrastructure, the cost savings involved in not having to upgrade infrastructure can provide better data to portfolio managers and traders to make more effective investment management decisions; and thereby potentially improve the performance metrics of the fund.

“Existing managers, as well as new launches are looking for better, cheaper and faster solutions that will scale cost-effectively as their business grows,” adds Branden Jones, Global Head of Marketing.

To illustrate how much interest there is on this aspect of hedge fund management, a recent white paper written by Liquid Holdings entitled “Critical Infrastructure: Primary Instrument to Generate Operational Alpha” has already attracted 200 downloads in just a few weeks. The overarching point made in the paper is that operations should be thought of as a quantifiable asset class, “one that not only supports performance but is a source of capital through the elimination of overhead costs.”

O’Boyle notes that hedge funds can take on a limited number of infrastructure projects. And when these are operationally-intensive projects, such as upgrading legacy systems, it puts the organization at a disadvantage.

“If you clean up the issues in the back-office you create an opportunity to focus on the front-office both from a reduction in expense and improving the data used for investment purposes. If you look at any medium-sized hedge fund, there tends to be a heavier staffing focus on the back-office to run and maintain systems and data intensive processes.

“If you eliminated that imbalance you’d be reducing bottom-line expenses. This is the New Normal facing hedge fund managers, where the focus is on leveraging technology in a way that legacy systems cannot, to simultaneously create operational alpha and enhance the investment decision making process,” says O’Boyle.

This quantum leap in technology has given birth to the new hedge fund paradigm. At its heart is the ability to generate institutional-quality infrastructure, with accurate data moving seamlessly across the entire organization, all the while availing of the cloud to avoid legacy issues. Today, this is helping front- and back-office teams work in much closer alliance.

This is especially helpful when it comes to the reporting process. Both investors and regulators alike demand accurate data. The more a manager can rely on technology to populate reports with the right information, the less of a compliance burden it becomes. This also helps mitigate reputational risk, should the manager convey erroneous data to its investors.

“In larger hedge funds you’d expect the portfolio manager to report first to their boss - the COO or CEO - before anything gets reported out to the investors or regulators. It’s not only therefore a question of reputational risk to the firm but to the portfolio manager as well,” says Jones.

This necessity for institutional-quality infrastructure, in order to meet these transparency demands, is a huge issue for today’s start-up manager. With management fees continuing to compress, the last thing they want to do is let their capital expenditure run wild. As the Liquid white paper points out:

The challenge for funds is to address investor expectations while simultaneously keeping overhead costs to a minimum in order to execute on long-term business plans. Harnessing operational alpha from the early stages of the business through to maturation will keep funds competitive.

“Institutional investors are not only looking at the pedigree of the team, they are also looking at the infrastructure they have in place. They want to know what internal controls are in place. Are they demonstrable and consistent? Can they demonstrate real-time insights into what’s driving performance in say their top five holdings and what is driving overall risk in the portfolio? What we’re seeing is that investors are becoming the new regulators,” comments Jones.

Flexibility to offer different mandates

Another aspect to operational alpha is the ability for managers to be flexible in terms of offering variations on the fund. Typically, this would be through managed account mandates, which require even more robust operations. Here, the challenge for managers is not just about delivering performance in the fund strategy but sticking within the confines of a managed account mandate.

Any manager who has the system infrastructure to handle the operational burden of running variations of the investment strategy is going to be better placed than their peers.

“This is a key issue in the hedge fund space right now,” says O’Boyle. “One of the big drivers for us is the ability to handle managed account mandates along with the core offshore fund and to be able to manage both in real time.”

“Investors demand the ability to modify their investment strategy as and when they feel it is necessary. The managed account is a great opportunity for a hedge fund to manage multiple investors within their hedge fund strategy and provide the level of governance and oversight that an investor is looking for.”

Problem is, a lot of systems simply aren’t able to handle the real-time demands of running multiple mandates. A pension fund with a USD100million managed account mandate is more than likely going to pick the phone up during the day to get a quick update from the portfolio manager. They might want a summary report sent that afternoon. They might want risk exposure figures for the last quarter. Whatever it may be, the manager has to be in a position to respond at anytime.

Pre-trade controls just as important as post-trade controls

“Many managers that we talk to initially say they don’t need real-time risk, but when you get into discussions with them and talk about what real-time risk really means, they quickly recognize the benefit and potential impact to their firm. It’s not surprising that everyone is conditioned to the legacy approach of 10 years ago. It’s a gratifying experience to get to work consultatively with a hedge fund and show them how they can absolutely transform the way they do business and reduce their costs,” says O’Boyle.

Post-trade risk management is important to the manager but having clear pre-trade compliance controls in place are just as important, especially in the context of running managed account mandates as mentioned above. Managers want reassurances that should a trading mistake be made, its infrastructure will offer protection at the pre-trade level.

“If a trade is mistakenly made in a name or industry that the fund is mandated not to invest in, that trade can be identified and negated through system tracking before it hits the open market. When we talk about what investors are looking for in terms of internal controls, we are talking about pre-trade risk and compliance controls just as much as post-trade risk controls,” says Jones. “That’s where a lot of managers don’t pass the sniff test with institutional investors because their legacy vendors are unable to provide pre-trade controls at the sub-millisecond level. We do.”

Total cost of ownership – legacy systems erode profits and controls

Another key benefit of a cloud-based system is the lower total cost of ownership (TCO) it brings.

As O’Boyle puts it: “This is all about predictable total cost of ownership. It enables managers to spec out exactly what the spend will be from a technology/infrastructure standpoint over 18, 24, 36 months. It means they can invest in other parts of the business and know that those investments are not going to come back and bite them in say, Year 2 or Year 3 of the business.”

What this also does is give the manager a longer runway to build a stable business and track record.

Another aspect of the ‘operational alpha’ story is that whilst the hedge fund industry is now in its third generation of managers, it is still only in the second generation of technology deployment. Younger managers are much more open-minded and reliant upon cloud-based technology than older, more established managers who have been in the industry longer. For these older hedge fund managers, they’ve built an operational infrastructure over many years and are less reluctant to spend time and energy fixing something that isn’t necessarily broken.

“Managers need to own their technology environments, period,” says Jones. “This is the only way to achieve the real measure of independence, control, and flexibility necessary to responsibly oversee a portion of the future pension of a 3rd grade teacher from the State of Ohio. Hedge Funds large and small have a choice: pay a huge premium for outdated legacy systems, or select a forward-thinking solution that allows them to achieve operational alpha alongside the performance alpha of their investment strategy.”

When one talks about operational alpha, this extends beyond the technology benefits of legacy-free systems to include mobile technology. Being able to benefit from mobile technology on an iPad might, for example, enable a manager to showcase their fund’s track record, key metrics such as Value-at-Risk, and liquidity analysis, from a single, secure portal to potential investors at a conference. This is, in effect, putting operational alpha into practice.

“It is a clear signal to potential investors that you’re going to be able to service them in a way that perhaps no-one else in your peer group can. It also clearly shows that you have regulatory and operational oversight of your business at all times,” stresses O’Boyle, who concludes by saying:

“At the end of the day a hedge fund business is largely about meeting investor needs. Operational alpha can be as real of an asset class as any investment strategy when properly focused on.”